Model agencies collude to fix rates

Positive externalities

A positive externality is a benefit that is enjoyed by a third-party
as a result of an economic transaction. Third-parties include any
individual, organisation, property owner, or resource that is indirectly
affected. While individuals who benefit from positive externalities
without paying are considered to be free-riders, it may be in the
interests of society to encourage free-riders to consume goods which
generate substantial external benefits.

Most merit goods generate positive consumption externalities,
which beneficiaries do not pay for. For example, with healthcare,
private treatment for contagious diseases provides a considerable
benefit to others, for which they do not pay. Similarly, with education,
the skills acquired and knowledge learnt at university can benefit the
wider community in many ways.

Unlike the case of negative externalities, which
should be discouraged to achieve a socially efficient allocation of
scarce resources, positive externalities should be encouraged.

Encouraging positive externalities

One role for government is to implement
economic policies that promote positive externalities. There are two
general approaches to promoting positive externalities; to increase the
supply of, and demand for, goods, services and resources that generate
external benefits.

Increasing supply

Government grants and subsidies to producers of
goods and services that generate external benefits will reduce costs of
production, and encourage more supply. This is a common remedy to
encourage the supply of merit goods such as healthcare, education, and
social housing. Such merit goods can be funded out of central and local
government taxation. Public goods, such as roads, bridges and airports,
also generate considerable positive externalities, and can be built,
maintained and fully, or part, funded out of tax revenue.

Increasing demand

Demand for goods, which generate positive
externalities, can be encouraged by reducing the price paid by
consumers. For example, subsidising the tuition fees of university
students will encourage more young people to go to university, which
will generate a positive externality for future generations.

The ultimate encouragement to consume is to make
the good completely free at the point of consumption, such as with
freely available hospital treatment for contagious diseases.

Government can also provide free information
to consumers, to compensate for the information failure that discourages
consumption. If individuals are fully informed about the
benefits of consuming goods and services that generate external
benefits, they may develop a better understanding of the product and
demand more of it. For example, public information broadcasts, such as
aids awareness programmes, can reduce ignorance, and encourage the use
of condoms.

An additional option is to compel individuals to
consume the good or service that generates the external benefit. For
example, if suspected of having a contagious disease, an individual may
be forced into hospital to receive treatment, even against their will.
In terms of education, attendance at school up until the age of 16 is
compulsory, and parents may be fined for encouraging their children to
truant.

Net welfare loss

The existence of a positive externality means that
marginal social benefit is greater than marginal private benefit. For example, in considering the market for
education, free markets would supply quantity Q at price P. If the external
benefit is included, the socially efficient output rises to quantity Q1.

By consuming only quantity Q, marginal social
benefit is above marginal social cost, and more of the good should
be consumed. At Q, the marginal social cost is
A (Q – A), and the private benefit is also
A (Q – A) but
the marginal social benefit is C (Q – C). Therefore, if only Q is
consumed, there is an
opportunity cost to society, which is represented by the area
of welfare loss, A,
C, B.

Positive production externalities

A positive production externality
occurs when a third party gains as a result of production. However,
those third parties who benefit cannot be charged, so there is only an
incentive to supply to those who can be charged.

Positive production externalities
occur in many situations, most notably with the construction and
operation of infrastructure projects, such as a new airport, or
motorway.

Research and development
which leads to new technology is also a potential by-product of
production, which other firms can benefit from.

Firms usually try to protect
their inventions, but new technologies can quickly become shared and
generate widespread benefits.

The technology developed
alongside the internet,
such as the HTML language, is now the standard text editor for
commercial websites.